LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

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The Future of Class Actions for Securities Fraud

Cornerstone, in conjunction with the Stanford Securities Class Action site, just issued a mid-year report on class actions.  There were 78 new class actions filed in the first six months, down 13 from the last six months of 2013 (but 13 more than the first six months of that year).  

If the numbers simply double over the year (to some where around 155), the total number will be one of the lowest on record (only 120 were filed in 2006 and 152 in 2012, otherwise the number has not fallen below 166 in the prior 15 years).  Nonetheless, the rate seems to be consistent with the numbers since 2009, with filings falling in a narrow band of 152 to 188).  Of course, the stats do not take into account both a positive and a negative that can affect the rate of filings.  

The negative is Halliburton, which gave defendants additional ability to show that misrepresentations did not affect market price at the class certification stage.  The main effect is likely to be the dismissal of more cases at the class certification stage.  Nonetheless, it may also cause a decline in the number of suits as plaintiffs anticipate this possibility and decline to bring more marginal cases where the effect of the disclosure on market price is problematic.

The positive is that the stock market is at very high levels.  Should the market undergo a significant drop, there may be an increase in the number of lawsuits.  Thus, for example, the largest number of suits filed in recent years was 223 in 2008, when  the market collapsed.   


The Benefits of Tagged Data: A Short Case Study

Most data filed with the SEC is not "tagged" or structured. As a result, the data is not machine readable and any analysis must take place one filing at a time.

Financial statements are a significant exception. In 2009, the SEC put in place rules that required companies to file financial statements using XBRL. Companies were phased in, with the last tranche subject to the requirements in 2012.

Tagged data has many advantages. In particular it facilitates transparency by making data cheaper and easier to read and analyze. Nonetheless, there is resistance. Some in Congress are seeking to legislatively prohibit the SEC from requiring smaller companies to use XBRL. The approach is designed to provide smaller issuers (below $250 million) with a vague and potentially illusory short term savings (whatever the net costs, if any, associated with the tagging process) at a long term cost of reducing transparency and ultimately making investment more difficult.

With that in mind, we turn to the article in the WSJ on the practice by public companies of leaving taxable income overseas. According to the article, companies do so to avoid taxes in the United States. One consequence, however, is that companies have an incentive to borrow rather than bring the cash home. See Id.  ("Few corporations publicly say they are borrowing to avoid a tax hit, but analysts and economists say the dynamic is clear."). As a result, companies can simultaneously have record amounts of debt and record amounts of cash.   

The point is an interesting one but it was made more interesting by observations that appear to have been developed through an analysis of tagged data. According to the article: "Among more than 240 companies disclosing increases in unremitted foreign earnings in 2013, those with bigger increases tended to also see bigger increases in corporate debt, according to data from research firm Calcbench." 

The information, therefore, came from Calcbench. Calcbench operates an interactive data platform that permits analysis of the XBRL data provided to the SEC. The platform was able to identify the 240 companies filing financial statements with the SEC in 2013 that increased their unremitted foreign earnings.  

That straightforward sentence would have been impossible to make (at least in a cost effective manner) in an analog (that is, HTML) universe. Someone would have needed to pull every financial statement filed with the SEC in 2013 and every financial statement filed in 2012. Given the 10,000 or so SEC filers, this would have required the examination of some 20,000 sets of financial statements. They would then need to be compared to determine the companies that saw an increase in unremitted foreign earnings. 

This task, something that would probably take hundreds of hours, would produce a universe of 240 companies.  The next step would be to examine the filings to determine the relationship between foreign earnings and corporate debt. 

So a task that would potentially take hundreds of hours was likely done in minutes (possibly seconds). An investor in Japan might have undertaken this analysis to determine where to invest. Companies keeping cash abroad but taking on more debt may well have different risk profiles than those that bring the money home and avoid the debt (or at least it could be a factor in the risk profile). 

Yet if some in Congress have their way, the Japanese investor will not be able to easily conduct this analysis for emerging growth companies. With less information, the investor will presumably invest in other places.    

The SEC's Investor Advisory Committee has recommended that the SEC increase efforts to require that filed data be "tagged" or structured. Particularly with the ongoing evaluation of corporate disclosure, tagging should become the default. The benefits are becoming increasingly obvious. 

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here.    


Conflict Minerals, the DC Circuit, and the SEC: The Law of the Circuit Doctrine

In American Meat v. Department of Agriculture, Judge Henderson wrote a dissenting opinion that raised an issue of appellate procedure. She wondered how the case even got before the full court. Id. ("But, for the life of me, I do not understand how we got to the en banc stage in this case.").  


Her concern was that the original panel issued a decision that conflicted with a prior D.C. Circuit opinion. Based upon the law of the Circuit, one panel cannot overrule another. That is what Judge Henderson asserted had occurred. Id. ("The panel was also wrong for the simple reason that its merits decision—whether or not correct—did indeed 'contradict' our decision in R.J. Reynolds and therefore should not have issued."). 

The rule exists in the federal system (but not in all state systems) and ensures consistency within a circuit. When one panel speaks (on matters of law), subsequent panels must conform. That way litigants do not have to confront contrary legal interpretations within the same circuit. A subsequent panel can express distaste for the reasoning of the earlier decision but it must follow it. As Judge Henderson described: 

  • One of our court’s most fundamental governing principles is the “law of the circuit doctrine” which decrees that the decision of a three-judge panel of the court “is ‘the decision of the court.’ ” LaShawn v. Barry, 87 F.3d 1389, 1395 (D.C. Cir. 1996) (en banc) (quoting Revision Notes to 28 U.S.C. § 46). “One three-judge panel, therefore, does not have the authority to overrule another three-judge panel of the court.” Id.  

To the extent that the earlier panel needs to be changed, the only mechanism is en banc review (or reversal by the Supreme Court or effective reversal by Congress). As a result, it takes the full court to overturn the law propounded by a panel.  

In American Meat, the panel distinguished the precedent that Judge Henderson viewed as contrary. Judge Henderson, however, found "this conclusion untenable given the centrality of the R.J. Reynolds majority’s limited reading of Zauderer." As a result, "[b]ecause that reading constituted part of R.J. Reynolds’s holding, the 'power' to overrule it could properly 'be exercised only by the full court, either through an in [sic] banc decision or pursuant to the more informal practice adopted in Irons v. Diamond.' "  

Irons, by the way, involved the introduction of what amounted to an informal en banc consideration of the matter. See Iron, n. 11 ("The foregoing part of the division's decision, because it resolves an apparent conflict between two prior decisions, has been separately considered and approved by the full court, and thus constitutes the law of the circuit.").  

As for the consequences, Judge Henderson had this to say: "I need hardly add my hope that this case is an outlier; if not, we risk adopting the habit of slapping the 'dictum' label on any holding that any two of us find inconvenient and thereby replacing law of the circuit with law of the panel."  

The majority contained a single footnote responding to the assertions. 

  • Judge Henderson in her separate dissent criticizes the now vacated panel opinion for stating the panel’s view that the language of R.J. Reynolds and National Association of Manufacturers v. NLRB limiting Zauderer to instances of deception-correction did not constitute holdings. Whatever the merits of that view, the panel recognized that other judges might reasonably take the contrary view and accordingly called for the court to consider the scope of Zauderer en banc, a call to which the court responded affirmatively. The present opinion is the consequence.

Whatever the merits of the back and forth, this was a case of no harm, no foul. Had the panel followed the views of Judge Henderson, it would have ruled in a contrary fashion (having been bound by the earlier panel) but then either invited the parties to seek review en banc or requested such a review themselves. See D.C. Circuit Internal Procedures, at 58 ("If a judge calls for a vote on the petition for rehearing en banc, the Clerk’s Office transmits electronically to the full Court a new vote sheet, along with any response to the petition ordered by the Court.").  

In this case, the panel in American Meat effectively sought en banc review. As the opinion stated:  

  • We recognize that reasonable judges may read Reynolds as holding that Zauderer can apply only where the government’s interest is in correcting deception. Accordingly, we suggest that the full court hear this case en banc to resolve for the circuit whether, under Zauderer , government interests in addition to correcting deception can sustain a commercial speech mandate that compels firms to disclose purely factual and non-controversial information. 

Thus, there was no period of time when litigants in the D.C. Circuit had to confront conflicting panel opinions. Moreover, correction or clarification was done by the en banc court.

Nonetheless, Judge Henderson's reminder is a good one. Courts can, and do, circumvent the "law of the circuit doctrine." They can describe their holding as slightly different, characterize the earlier case as dictum, or point to subsequent developments that essentially render the prior opinion no longer valid (say an intervening Supreme Court decision). This has the risk of creating conflicting panel decisions and of creating confusion among the circuit decisions.  

For a discussion of appellate procedure and the process of assigning judges and cases to panels at the United States Court of Appeals, see Neutral Assignment of Judges at the Court of Appeals.   


Conflict Minerals, the DC Circuit, and the SEC: Agency Deference Returns

We have written often about the unfriendly nature of the D.C. Circuit towards the SEC. The most glaring example was Business Roundtable v. SEC when the court struck down the shareholder access rule on spurious grounds.

The tone and degree of deference has shifted since the court was brought to full staff through the appointment of three additional members by the current President. The shift does not rule out the possibility of a panel unfriendly to the SEC but does provide a mechanism for correction through an en banc hearing.

In the conflict minerals case, the SEC largely won. It was an administrative law victory. Nonetheless, a portion of the rule was struck down on aggressive First Amendment grounds. The analysis was also notable given that the First Amendment issue had already been taken up by the D.C. Circuit en banc in another case, American Meat v. Department of Agriculture. As a result, the panel in the conflicts minerals case could have but did not wait for the outcome of that decision.  

The SEC, therefore, implemented the conflicts mineral rule save only the portions struck down. With respect to that portion of the opinion, the SEC sought a stay pending the en banc hearing (for earlier posts on the SEC's strategy, see one here and here).

The en banc opinion just came down. See Am. Meat Institute v. Dept. of Agric.  In a sweeping victory for administrative agencies, the court upheld "label of origin" rules with respect to certain meat products by a resounding 9-2 (there were two concurring opinions). The en banc court agreed that Supreme Court precedent was not limited to deception. Nonetheless, the government still had to show a "substantial" interest in restricting speech. On that, there was not much guidance.   

  • Beyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice. Beyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice.

The Department of Agriculture made the requisite showing. 

  • But here we think several aspects of the government’s interest in country-of-origin labeling for food combine to make the interest substantial: the context and long history of country-of-origin disclosures to enable consumers to choose American-made products; the demonstrated consumer interest in extending country-of-origin labeling to food products; and the individual health concerns and market impacts that can arise in the event of a food-borne illness outbreak. Because the interest motivating the 2013 rule is a substantial one, we need not decide whether a lesser interest could suffice under Zauderer.

The SEC will, therefore, have to make a "substantial" showing to justify the portions of the conflict minerals rule that were invalidated by the panel opinion.

Whatever the outcome of the conflict minerals case from here, American Meat has considerably strengthened the "disclosure" hand of administrative agencies generally and the SEC specifically. What the case really shows, however, is that the views of the circuit are shifting. There seems to be less antagonism towards the administrative process. The decision should demonstrate to administrative agencies that the litigation risk in the rule making area has undergone a significant drop.  


Implicit Holding of Conflict Minerals Rule Case Overruled: Zauderer Review Broadened

We have posted many entries (a few are here and here) on the complex legal fight over the validity of the SEC’s conflict minerals rule (the “Rule”).  And now it is time for another as the recent decision in American Meat Institute v. USDA overturns an implicit holding of that case—specifically that Zauderer rational basis review applies only to disclosures aimed at preventing consumer deception.

As was discussed in earlier posts, while the SEC largely prevailed in the fight over the validity of the Rule, it lost the First Amendment argument when NAM v SEC reached the DC Court of Appeals.  The National Association of Manufacturers had challenged the Rule’s requirement that an issuer describe its products as not “DRC conflict free” in its conflict minerals report, claiming that the requirement unconstitutionally compels speech.

In deciding NAM v SEC the Court noted that Zauderer v. Office of Disciplinary Counsel, which allowed rational basis review to  be applied to compelled disclosure requirements, was limited to cases in which such requirements are "reasonably related to the State’s interest in preventing deception of consumers" and pointed out that “[n]o party has suggested that the conflict minerals rule is related to preventing consumer deception. In the district court the Commission admitted that it was not.”  The Court made this statement even though the scope of Zauderer was very much at issue.

In American Meat, the DC Court of Appeals, sitting en banc, took up the question of whether country of origin labeling rules violated the First Amendment.  Of key importance was the application of Zauderer.  The Court noted that all parties agreed that:

Zauderer applies to government mandates requiring disclosure of “purely factual and uncontroversial information” appropriate to prevent deception in the regulated party’s commercial speech. The key question for us is whether the principles articulated in Zauderer apply more broadly to factual and uncontroversial disclosures required to serve other government interests.

Zauderer had left open the “key question” but the Court of Appeals found that:

The language with which Zauderer justified its approach, however, sweeps far more broadly than the interest in remedying deception. After recounting the elements of Central Hudson, Zauderer rejected that test as unnecessary in light of the “material differences between disclosure requirements and outright prohibitions on speech.” Zauderer, 471 U.S. at 650. Later in the opinion, the Court observed that “the First Amendment interests implicated by disclosure requirements are substantially weaker than those at stake when speech is actually suppressed.” Id. at 652 n.14. After noting that the disclosure took the form of “purely factual and uncontroversial information about the terms under which [the] services will be available,” the Court characterized the speaker’s interest as “minimal”: “Because the extension of First Amendment protection to commercial speech is justified principally by the value to consumers of the information such speech provides, appellant’s constitutionally protected interest in not providing any particular factual information in his advertising is minimal.” Id. at 651 (citation omitted). All told, Zauderer’s characterization of the speaker’s interest in

opposing forced disclosure of such information as “minimal” seems inherently applicable beyond the problem of deception, as other circuits have found. (citations omitted).

To be sure that there could be no confusion over its holding that Zauderer rational review is not limited to disclosure requirements aimed at preventing consumer deception the Court expressly stated:

To the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.1See, e.g., Nat’l Ass’n of Mfrs. v. SEC, 748 F.3d 359, 370-71 (D.C. Cir. 2014); Nat’l Ass’n of Mfrs. v. NLRB, 717 F.3d 947, 959 n.18 (D.C. Cir.2013); R.J. Reynolds Tobacco Co. v. FDA, 696 F.3d 1205, 1214 (D.C. Cir. 2012).

This does not mean that the Rule will now withstand First Amendment scrutiny.  American Meat makes clear that rational review extends to disclosure requirements that do more than aim to prevent deception but also makes clear that it applies only when such requirements call for disclosure of “purely factual and uncontroversial information.”  In NAM v. SEC the DC Court of Appeals also found that the requirement of the Rule that issuers state when their products were not “conflict free” went beyond this type of statement. 

Specifically, the Court of Appeals asserted:

  • At all events, it is far from clear that the description at issue—whether a product is “conflict free”—is factual and non-ideological. Products and minerals do not fight conflicts. The label “conflict free” is a metaphor that conveys moral responsibility for the Congo war. It requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups. An issuer, including an issuer who condemns the atrocities of the Congo war in the strongest terms, may disagree with that assessment of its moral responsibility. And it may convey that “message” through “silence.” See Hurley, 515 U.S. at 573. By compelling an issuer to confess blood on its hands, the statute interferes with that exercise. 

Further, American Meat makes clear that even if Zauderer review is applied, not all disclosure requirements will pass muster.  The test in Zauderer states “commercial speech that is not false or deceptive and does not concern unlawful activities may be restricted only in the service of a substantial governmental interest, and only through means that directly advance that interest.”  It does not define “substantial governmental interest” and the court in American Meat agreed that “[b]eyond the interest in correcting misleading or confusing commercial speech, Zauderer gives little indication of what type of interest might suffice. In particular, the Supreme Court has not made clear whether Zauderer would permit government reliance on interests that do not qualify as substantial under Central Hudson’s standard, a standard that itself seems elusive.”

While the American Meat court found the governmental interest in the country of origin labeling rules to be sufficiently substantial to justify the required disclosure, it is unclear whether the Rule would be found to be compelled by such substantial interests.  Thus, it is entirely likely that the requirement that issuers describe certain product as “non-conflict free” would still be found to be in violation of the First Amendment.  

Still, American Meat has important implications for the Rule and beyond.  With respect to the Rule, it is possible, according to Peter Bible, chief risk officer for accounting firm EisnerAmper, that “[c]ompanies that use these minerals in their products may decide it’s better to issue reports to the federal government that most consumers won’t see rather than face the prospect of having to put a label on their products saying they contain minerals from conflict zones.”

“That would be more powerful to consumers and might compel some of them to put a product back,” Mr. Bible said. “If you think the consumer is going to reject your product because of the disclosure, obviously you will want to stay with the conflict rules as they are presently written. The safe thing to say is this is a spark. Whether it ignites we have yet to see, but clearly this will result in some follow-on effects or consequences… and companies are going to have to follow this.”

Beyond its impact on NAM v. SEC, American Meat is of great importance in its clear statement that Zauderer review extends beyond disclosure requirements aimed at preventing consumer deception.  Those fighting against disclosure requirements will now have to work harder than if Zauderer had been so limited. For those who feared that NAM v. SEC would significantly limit the use of disclosure regulation not aimed at preventing deception, American Meat sounds a far more hopeful note


Staff Guidance, Accredited Investors, and Exchange Rates

CorpFin has issued some staff guidance in connection with accredited investor status.  The guidance is here (dated July 3, 2014).  One question concened the calculation of income that is not reported in US dollars.   


Question 255.48

Question: If a purchaser's annual income is not reported in U.S. dollars, what exchange rate should an issuer use to determine whether the purchaser's income meets the income test for qualifying as an accredited investor?

Answer: The issuer may use either the exchange rate that is in effect on the last day of the year for which income is being determined or the average exchange rate for that year.

The approach provides some opportunity for manipulation.  The IRS publishes yearly averages.  Treasury provides year end exchange rates. In general, the yearly averages are lower.  As a result, in marginal cases, use of the yearly average will qualify more individuals than the year end rate, although this is not always the case (China 2013 rate:  Year end: 6.0540; yearly average:  6.446).

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here.    


Staff Guidance, Accredited Investors, and "Reasonable Steps": The Use of Foreign Tax Returns

The income safe harbor in Rule 506(c) permits income verification through the use of tax returns. Tax returns were permitted because they were deemed reliable since they were subject to "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013).

The staff responded to a question about foreign tax returns.   

  • Question: A purchaser is not a U.S. taxpayer and therefore cannot provide an Internal Revenue Service form that reports income. Can an issuer review comparable tax forms from a foreign jurisdiction in order to rely on the verification method provided in Rule 506(c)(2)(ii)(A)? 

The returns did not squarely fit within the safe harbor.  Nonetheless, they were deemed acceptable so long as they were subject to "comparable penalties" for false filings as those imposed in the US.   

  • Answer: No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances. In adopting this safe harbor, the Commission noted that there are "numerous penalties for falsely reporting information" in Internal Revenue Service forms. See Securities Act Release No. 33-9415 (July 10, 2013). Although the safe harbor is not available for tax forms from foreign jurisdictions, we believe that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by reviewing filed tax forms that report income where the foreign jurisdiction imposes comparable penalties for falsely reported information. 

The staff also remineded issuers that additional verification was necessary where the company had "reason to question the reliability of the information about the purchaser's income after reviewing these documents".  

It is highly probable that all countries have on the books penalties for false tax returns.  As a result, the import of the staff guidance is that a foreign return is always acceptable.  The problem with the approach is that comparable penalties are only as good as the system of enforcement.  In plenty of countries, corruption is rampant and there is no guarantee that documents filed with the government will be accurate.  See Brazil's secret fiscal weapon: the tax 'lion', Reuters, May 8, 2012 ("Several Latin American countries such as Mexico and Paraguay are believed to lose as much as half of potential tax revenues to evasion and lax enforcement. ").  

Where there is lax enforcement, the imposition of "comparable penalties" does not act to ensure accuracy.  Nonetheless, establishing accredited investor status is mosly a matter of making sure that investors meet the income and asset requirements.  In most cases, individuals will not be likley to overstate their income (understatement is a more likely problem).  The issue with making foreign returns easy to use is an increased risk of fraudulent returns.  Particularly with respect to affinity fraud aimed at particular ethnic groups, much of the relevant documentation may arrive in the form of "returns" written in a foreign language.  These will most likely be difficult to verify.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here.   


Staff Guidance, Accredited Investors, and "Reasonable Steps": Rewriting the Safe Harbor for Income Verification

Rule 506(c) allows issuers to market private placements through general solicitations. They must, however, take "reasonable steps" to make certain that they sell only to accredited investors. The rule provides some non-exclusive safe harbors with respect to the "reasonable steps" that will ensure conformity with the rule.

With respect to income, the safe harbor essentially requires verification based upon an IRS form. As the rule states: 

  • In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser's income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

The safe harbor, therefore, suggests that a variety of documents can be submitted to meet the requirement. Moreover, while the safe harbor speaks about the "income" for the year, presumably any combination of these documents would be sufficient to show that the investor had annual income in excess of the thresholds in Regulation D.     

The staff received a question, however, as to the verification of income for a year when the relevant "form" was not yet completed.  As the question stated: 

  • Rule 506(c)(2)(ii)(A) sets forth a non-exclusive method of verifying that a purchaser is an accredited investor by, among other things, reviewing any Internal Revenue Service form that reports the purchaser's income for the "two most recent years." If such an Internal Revenue Service form is not yet available for the recently completed year (e.g., 2013), can the issuer still rely on this verification method by reviewing the Internal Revenue Service forms for the two prior years that are available (e.g., 2012 and 2011)?  

The existing safe harbor seemed to implicitly address that question. The safe harbor was not limited to tax returns. Income could also be verified through the submission of a variety of forms, whether W-2s or 1099s or other IRS forms. These forms might not show the "income for the . . . most recent year[]" but would establish that the investor exceeded the relevant threshold.  

Yet the staff took the opportunity to effectively expand the reach of the safe harbor. The staff conceded that the safe harbor was not available in these circumstances ("No, the verification safe harbor provided in Rule 506(c)(2)(ii)(A) would not be available under these circumstances."). Nonetheless, it then proceeded to rewrite the safe harbor and make it available.    

  • We believe, however, that an issuer could reasonably conclude that a purchaser is an accredited investor and satisfy the verification requirement of Rule 506(c) under the principles-based verification method by:  
  1. reviewing the Internal Revenue Service forms that report income for the two years preceding the recently completed year; and
  2. obtaining written representations from the purchaser that (i) an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available, (ii) specify the amount of income the purchaser received for the recently completed year and that such amount reached the level needed to qualify as an accredited investor, and (iii) the purchaser has a reasonable expectation of reaching the requisite income level for the current year. 

This is a substantial change in, and weakening of, the safe harbor.  

First, the requirement at least implicitly ties verification to the need for a tax return. It is enough to show that "an Internal Revenue Service form that reports the purchaser's income for the recently completed year is not available." Since individuals often have multiple sources of income (W-2, 1099, K-1, etc), no single IRS "form" will report "income for the "recently completed year" except a tax return. Thus, even if other IRS forms are available, as long as the tax return is unfiled, self-certifified, and without accompanying documentation it is permitted.  

Second, the advice does not address the possibilty that the filing date of the tax return can be manipulated. Extensions (the first of which is more or less automatic) can result in tax returns not being filed for a year or longer. 

Third, the staff replaced the need for a document filed under penalties of perjury (an IRS document) with self certification, which has no such requirement. The staff took this position despite the fact that the Commission emphasized in the adopting release the importance of requiring documentation that was subject to "penalties for falsely reporting information." See Exchange Act Release No. 69959 (July 10, 2013) ("With respect to the verification method for the income test, there are numerous penalties for falsely reporting information in an Internal Revenue Service form, and these forms are filed with the Internal Revenue Service for purposes independent of investing in a Rule 506(c) offering.").  

Fourth, while the interpretation requires the examination of IRS documents for two earlier years, it does not impose any explicit obligations that must arise from that analysis. Where, for example, the earlier year shows an income amount that does not qualify, the guidance does not specify that this requires greater diligence. Indeed, the guidance provides that in some cases further investigation (additional verification) will be required but does not reference data from the earliest of the returns. 

  • Where the issuer has reason to question the purchaser's claim to be an accredited investor after reviewing these documents, it must take additional verification measures in order to establish that it has taken reasonable steps to verify that the purchaser is an accredited investor. For example, if, based on this review, the purchaser's income for the most recently completed year barely exceeded the threshold required, the foregoing procedures might not constitute sufficient verification and more diligence might be necessary. 

The guidance alters the income safe harbor in a manner arguably inconsistent with the representations made in the adopting release in Rule 506(c). The safe harbors were designed to eschew self-certification. They were designed to implement the "reasonable steps" requirement primarily through third party documentation of income and net assets. The guidance in this case, however, has undone much of that approach, permitting self certification in place of third party verification.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here


Staff Guidance, Accredited Investors, and Civil Unions

CorpFin put out some staff interpretations of the standards for accredited investors. They are dated July 3, 2014 and can be found here.  

The definition of accredited investor in Rule 501 of Regulation D (17 C.F.R. 230.501) provides a net asset test. The test looks to the assets of the investor singularly or together with a spouse. See Rule 501 ("Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000"). Use of the term "spouse" is limiting and predates the advent of civil unions.  

One query addressed by the staff was whether assets jointly owned "with another person who is not the purchaser's spouse" can be "included in determining whether the purchaser satisfies the net worth test in Rule 501(a)(5)?" The staff had this to say: 

  • Yes, assets in an account or property held jointly with a person who is not the purchaser's spouse may be included in the calculation for the net worth test, but only to the extent of his or her percentage ownership of the account or property. 

In other words, the full value of the asset cannot be included; only the actual value attributed to the investor. The answer also suggests that the SEC will accept a valuation based upon percentage ownership (say 50-50), the formula that would presumably be used in connection with ownership in common. Joint ownership provides that the survivor takes the entire property (the definition is here). The SEC's approach, therefore, does not take into account the value associated with survivorship. Nonetheless, it is easy and straightforward.  

The more significant concern is the exclusion of values related to non-spouses. The term "spouse" is not defined (certainly not in Regulation D and apparently not in the securities laws). While there is presumably no issue that "spouse" includes persons involved in same sex marriages, the issue of "civil unions" is far from clear.  

Civil unions and civil partnerships have become a permanent part of our legal landscape and social order. State statutes permitting the relationships have indicated that civil unions/partnerships are designed to have the same rights and benefits as marriage. The staff has not, however, explicitly taken the position that these relationships are included in the term "spouse."  

In other circumstances, the Commission has included the concept of "spousal equivalent." The term “spousal equivalent” was first employed in 2000 when the Commission amended the standards for auditor independence. The term was defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” The Commission has not, however, addressed whether the term includes civil unions or civil partnerships.  

The issue is in play with respect to the crowdfunding proposal. My comment letter discussing this issue at length (in the context of the crowdfunding proposal) can be found here. The easiest solution would be for the staff to issue guidance clarifying that spouse includes partners in a civil union/partnership. To the extent that does not occur, the ongoing analysis of the accredited investor definition should include a recommendation that the rule be amended to explicitly include these relationships in the income/net asset tests.  

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom. Instructions for doing so are here


Market Structure Reform and the SEC (Part 2)

Professor Coffee, in his piece in the Columbia CLS Blue Sky Blog, High Frequency Trading Reform: The Short Term and the Longer Term, raises structural concerns with the market and asserts that the SEC has been slow to implement reforms. As he colorfully notes: "[T]he SEC has studied high frequency trading at length, but seems unable to do much more than re-arrange the deck chairs on the Titanic." He then offers an explanation of sorts. The answer is not capture.   

  • Some will allege that the SEC has been “captured,” but that charge seems misplaced in this context, because the industry is itself intensely divided. The exchanges are doubtful about the “maker/taker” system that has become dominant in the wake of Regulation NMS, and the Securities Industry and Financial Markets Association (“SIFMA”), the industry trade group, wants major reforms. But the dark pools are largely owned by major banks, who have a different agenda. 

Instead, the answer is workload and a predilection for the status quo.  

  • Thus, the SEC’s inactivity seems better explained by two factors: (1) the SEC has been overextended by the demands of implementing Dodd-Frank and thus avoids issues that it can sidestep; and (2) in the field of market regulation, the SEC’s staff tends to worship at the Shrine of the Status Quo. Whatever practices have become prevalent are assumed to be efficient. But trading has evolved very rapidly since the adoption of Regulation NMS in 2007, and it is far from clear that any natural equilibrium has been reached. 

Capture, of course, need not be by the entire industry but can be by a particular segment. So a divided industry does not preclude capture.  

The explanation of worship of the status quo, however, overlooks a great deal. The Commission has indicated serious concern with market structure issues. The absence of any significant proposals to date have a number of likely explanations.   

First, the area is exceedingly complex. Identifying problems and solutions is not always easy.  Second, the Commission is divided politically; this probably makes consensus on reforms difficult. Third, there is almost certainly real concern that "reforms" may generate negative consequences that exceed any benefits. After all, a number of areas of concern are explained or at least influenced by the existing regulatory construct. Maker-taker payments, for example, operate within the caps on access fees in Regulation NMS. Significant changes will almost certainly have unintended consequences.   

Fourth, the very division within the securities industry makes reform difficult. The Commission is at its best when implementing regulatory reform that reflects industry consensus. A consensus can ensure that no single sector bears the brunt of systemic reform. That is not the case here. Many of the proposed reforms would disproportionately affect particular segments of the securities industry.

Fifth, some of the complaints about high frequency trading have a luddite feel. At least some of the advantages of HFT arise out of advances in technology. Any regulatory intervention needs to prevent harmful practices without unnecessarily restricting technological advances.    

Finally, the Commission knows that anything it does will potentially be subject to litigation (although hopefully the change in the make-up of the D.C. Circuit should reduce concerns with this possibility) and hearings on the Hill. 

This is not to say that Eric Schneiderman and private law suits don't have a role in prodding the SEC. They do. Schneiderman has been at the forefront of raising the advance peak problem whereby high frequency traders receive information before the rest of the market (his pressure on wire services to end advance disclosure is an example). The Lanier case illustrates some of the problems associated with the distribution of proprietary data by exchanges before it appears in the CTS.

So the cases are less about changing the worshiping practices of the SEC and more about pointing the Agency in the right direction.    

The ABA Journal is again accepting nominations for their Blawg 100. Please consider nominating the Race to the Bottom.  Instructions for doing so are here


Records Requests and the Caremark Standard At Issue in Delaware

Flying somewhat below the radar, the on-going case of Indiana Electrical Workers Pension Trust Fund IBEW v. Wal-Mart Stores Inc. may prove to be one worthy of closer consideration. The case stems from the alleged involvement of Wal-Mart in a Mexico bribery scheme which was the subject of an extensive expose in a New York Times article.   

As distilled by  Ben W. Heineman, Jr. a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government, the essential allegations in the Times story are as follows:

  • For a substantial period before 2005, the CEO of Wal-Mart in Mexico and his chief lieutenants, including the Mexican general counsel and chief auditor, knowingly orchestrated bribes of Mexican officials to obtain building permits, zoning variances and environmental clearances, and also falsified records to hide these payments. When the lawyer in Mexico directly responsible for bribery payments had a change of heart and reported the scheme to Wal-Mart lawyers in the United States, those lawyers hired an independent firm which, after an initial look, recommended a major inquiry.

This was rejected by senior Wal-Mart management, which instead told an internal Wal-Mart investigative unit to look into it. That unit, too, said, in early 2006, that a substantial inquiry was warranted. But top Wal-Mart leaders in the U.S., including the company’s general counsel, referred the matter back to the Wal-Mart general counsel in Mexico – the very lawyer who was allegedly at the center of the bribery scheme. Unsurprisingly, the Mexican general counsel promptly closed the matter, finding no problems and suggesting no disciplinary measures for senior Wal-Mart leaders in Mexico. He remained in his position until relieved of his duties just before the Times story appeared.

After publication of the article, the Indiana Electrical Workers Pension Trust Fund IBEW, who had received copies of the same files leaked by a whistleblower to The New York Times filed suit in August of 2012 seeking information to enable it to proceed with a derivative action against Walmart alleging that Walmart’s board had failed in its oversight responsibilities and engaged in a cover-up of the alleged scheme.  The gist of the case involved a claim brought under Delaware General Corporation Law §220.   In the initial action, then-Chancellor Strine, now chief justice of the Supreme Court, ordered Wal-Mart to hand over certain internal files (but not all the fund sought) concerning what its directors knew about certain bribery claims, including allegations that certain executives paid bribes to facilitate Mexican real estate deals, in violation of the Foreign Corrupt Practices Act.  (Ind. Elec. Workers Pension Trust Fund IBEW v. Wal-Mart Stores, Inc., Del. Ch, No. 7779-CS, 5/20/2013).

Walmart appealed and the Indiana Electrical Workers Pension Trust fund cross-appealed the decision.  Oral arguments on the appeal were heard on July 10th before the Delaware Supreme Court.  The Court will decide, among other issues, if Wal-Mart should release the files of the senior executives who briefed the directors, the Board’s Audit committee, and Maritza Munich, Walmart’s in-house counsel who resigned after the investigation was closed. 

While this may not seem worth of note—Section 220 cases are common and their impact is typically limited to the parties involved in the action there has been much speculation in certain circles that the Delaware Supreme Court could use it as an opportunity to revisit and clarify the Caremark standard.

Under Caremark, “a director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by non-compliance with applicable legal standards.”  The case did not articulate any specific requirements as to the nature and quality of the oversight process.  It simply required that one be in place.

According to some commentators, including Michael Volkov, CEO of The Volkov Law Group LLC and a regular speaker on compliance, internal investigations and enforcement matters,  “[t]he Wal-Mart case presents a set of circumstances where the court could find that Wal-Mart failed to meet the threshold standard or, more importantly, failed to exercise proper oversight and monitoring of the compliance program in accordance with a more stringent standard reflecting an up-to-date recognition of the change in corporate governance requirements and expectations since the Caremark decision.

At oral argument, the Justices seemed unsure how far to extend the reach of a Section 220 books and records request and it is unclear whether the case will work any changes in the Caremark standards or not.

Justice Randy J. Holland asked Mr. Grant, counsel for the Indiana Electrical Workers about the about the purpose of its § 220 complaint.  “You are trying to ascertain if there are red flags that they board should have known” or did know about “but did nothing about?” Holland said.

Grant agreed, adding that communications and documents relating to internal auditors, audit committee member, internal investigators and former Wal-Mart compliance officer Maritza Munich are also needed to make that determination.

Justice Carolyn Berger emphasized that IBEW should be only entitled to documents that meet the “necessary and essential” standard. Berger expressed concern that what the IBEW wanted goes too far for the § 220 stage. “The description of what you would get sounds a lot like what you would get in normal discovery,” she said.

Stuart H. Deming, founder of Deming PLLC, suggests that the case could have sweeping ramifications for corporate compliance programs.

“A decision enforcing the rights of shareholders in this context should certainly heighten the sensitivity of boards of directors to their obligations under Caremark,” Deming, who represents foreign and domestic companies in a range of compliance matters.

Even if the case does not fundamentally change the Caremark analysis, some believe it will have important implications for boards of directors. 

According to Mr. Deming, “even if an opinion is issued that does not enforce the rights of shareholders in the context of the circumstance associated with Wal-Mart, the mere fact that the issue has been raised is likely, at least in the short run, to have an impact in heightening the sensitivity of boards of directors to compliance obligations.” 

It is beyond doubt that the Caremark decision could use amplification.  As corporate compliance becomes the focus of increased attention, guidance as to what constitutes adequate oversight could help both boards and shareholders.


The Significance of Halliburton

The Supreme Court in Halliburton, by a 6-3 majority, reaffirmed the presumption of fraud on the market. Halliburton, like Matrixx, was more significant for what it didn't do rather than what it did. The case held out the possibility that the reliance requirement would be radically changed. The Court could conceivably have adopted an actual reliance requirement that would have largely put an end to class actions in the area of securities fraud.  

The decision was disappointing to some. The folks at Wachtell noted that "[t]he case had the potential to revolutionize securities litigation, but, as decided, it will work no such change." The case did, however, impose additional burdens on plaintiffs by allowing defendants, at the class certification stage, to challenge reliance, primarily by showing the absence of "price impact." As Professor Coffee suggested, rather than plaintiffs entirely dodging a bullet, "The bullet hit, but inflicted a non-fatal wound."  

In truth, the case is not likely to have a significant impact on class actions alleging violations of the antifraud provisions. Costs will go up. Defendants will hire economists to conduct event studies in an effort to show that the alleged misrepresentations had no price impact. Plaintiffs will have to present evidence to the contrary. But these cases are already expensive and the firms on the plaintiffs side that bring them must have deep pockets. The pockets will now need to be just a little bit deeper.

On the other hand, the decision may have unintended consequences. To the extent that a class action suit survives this type of challenge, the settlement amount will likely go up. By quantifying the extent of the market impact, plaintiffs will have better evidence of alleged damages and will be in a position to insist on larger settlement amounts.   

What this case demonstrates, however, is that the limits on class actions are unrelated to the merits. The standard for scienter (the strong inference standard) doesn't really separate the wheat from the chaffe as much as it separates those where the evidence of scienter is publicly available and those where it is not. Likewise, there is no reason to believe that Halliburton will actually result in the dismissal of meritless cases. Instead, cases will be dismissed based upon the imprecise ability to show the market impact of a false statement.


United States v. Matthew Martoma: Denial of Martoma’s Motion to Dismiss

In United States v. Martoma, 2013 WL 6632676 (S.D.N.Y. Dec. 17, 2013), defendant, Matthew Martoma (“Martoma”), was indicted in Count One for conspiracy to commit securities fraud and in Counts Two and Three for securities fraud. The United States District Court for the Southern District of New York denied Martoma’s motion to dismiss under Morrison v. National Australia Bank, holding that Rule 10b-5 applied to the transactions because they occurred in the United States. 

According to the allegations, Martoma employed an expert-networking firm to facilitate paid consultations with medical experts in the pharmaceutical industry. The firm expressly warned clients that the consultation dialogue should be limited to information already in the public domain. Between 2006 and 2008, Martoma allegedly used the network to form relationships with two doctors (“Doctor One” and “Doctor Two”) involved with clinical trials for a new Alzheimer’s drug being conducted on behalf of two pharmaceutical giants, Élan Corporation and Wyeth Pharmaceuticals, Inc.

During this period, Martoma allegedly organized and attended approximately 42 consultations with Doctor One, who served on the trial’s Safety Monitoring Committee (“SMC”). The indictment alleged that Doctor One gave Martoma confidential information relating to the safety of the new drug. Further, the indictment contended that Martoma obtained confidential information from Doctor Two as well. After receiving the confidential information, Martoma allegedly purchased both Élan and Wyeth stock and instructed his hedge fund employer to do the same.

In July 2009, Doctor One purportedly provided Martoma with additional information indicating that the Alzheimer’s drug was ineffective. Prior to informing the public of the drug’s inefficacy, the government asserted that Martoma caused his employer to sell “virtually all of its approximately $700 million worth” of holdings in Élan and Wyeth. The hedge fund also initiated various short sales and options strategies to profit from any decline in the company’s stock. These actions, according to the government, caused the fund to realize profits and avoid losses equal to $276 million. 

Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” In Morrison v. National Australia Bank LTD., 561 U.S. 247 (2010), the Supreme Court concluded that Rule 10b-5 did not have extraterritorial effect.  For the provision to apply, the transaction at issue had to involve (1) the purchase or sale of a security listed on a US stock exchange, or (2) the purchase or sale of any other security that took place in the United States.

Martoma moved to dismiss Count Two and related parts of Count One, arguing that Section 10(b) did not apply because the subject transactions involved American Depository Receipts (“ADRs”) in Elan Corporation. The court found that the transaction met both tests under Morrison.  Although noting that ADRs could be characterized as “predominantly foreign securities transactions,” the Elan ADRs were listed on “an official American securities exchange.” 

In addition, the transactions occurred in the U.S. and not, as Martoma asserted, in Ireland.  Martoma focused on the fact that the actual shares were on deposit with the Bank of Ireland. The ADRs, in contrast, were “merely ‘receipts that may be redeemed for the foreign stock at any time,’” and, as a result, the “[t]he operative transaction for the issuance of Elan's ADRs— i.e., the deposit of Elan ordinary shares with The Bank of Ireland—was carried out in Ireland.”   

The court, however, disagreed.  Whatever the characterization of the ADRs, the focus of the analysis under Morrison was “where the transactions in the ADRs took place.”  Because the ADRs were listed on the NYSE, the relevant trade contracts, the passing of title, and the liability incurred by both parties to the transaction took place within the United States.

For the foregoing reasons, the court upheld the applicability of Rule 10b-5 to the present facts and denied Martoma’s motion to dismiss.  

The primary materials for this case may be found on the DU Corporate Governance website. 


Hufnagle v. Rino International Corp.: Plaintiff Adequately Pleads Scienter in Claim for Securities Fraud against Company's Auditor

In Hufnagle v. Rino Int’l Corp., CV 10-08695, 2013 WL 3976833 (C.D. Cal. Aug. 1, 2013), the United States District Court for the Central District of California denied defendant Frazer Frost, LLP’s ("Defendant") motion to dismiss plaintiff’s Third Amended Complaint ("Complaint") and held that Susan Hufnagle, individually and on behalf of those similarly situated(collectively “Plaintiff”), properly alleged scienter under Section 10(b) of the Securities Exchange Act of 1934 (“§ 10(b)”).

In the original Complaint, Plaintiff alleged that Rino International Corporation ("Rino"), Rino’s management, and Defendant--who is Rino’s auditor--conducted widespread fraud regarding Rino's Chinese industrial equipment business. The allegations include overstating revenue and profits, understating tax liability, and concealing transactions between Rino and companies managed by Rino’s CEO’s relatives. After filing the Complaint, Plaintiff entered into a settlement agreements with all defendants except Defendant.

In the Complaint, Plaintiff alleged that Defendant knowingly or recklessly ignored financial irregularities, failed to follow generally accepted auditing standards when he reviewed Rino’s financial statements, and issued false opinions concerning Rino’s financial statements.

In order to adequately plead a securities fraud claim under § 10(b) and Rule 10b-5, a plaintiff must allege facts that show (1) a material misrepresentation or omission of fact, (2) scienter, (3) a connection with the purchase or sale of a security, (4) transaction and loss causation, and (5) economic loss. Cases brought under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), like Plaintiff's, must also meet the PSLRA’s heightened pleading standard, which requires a complaint to state with particularity facts giving rise to a strong inference that the defendant acted with scienter. If particular facts, when viewed individually, do not support a strong inference of scienter, a court must conduct a holistic review of the allegations. When viewed holistically, individually insufficient allegations can support a strong inference of scienter.

Defendant’s motion to dismiss specifically challenged whether Plaintiff had adequately plead scienter.

Plaintiff argued the court should draw a strong inference of scienter from the fact Defendant had actual knowledge that Rino kept two sets of corporate books, one of which provided inflated revenues and profits to investors, and Defendant informed Rino’s management of significant deficiencies in Rino’s internal financial controls.

The court found the alleged facts gave rise to what it described as both "innocent" and "malicious" inferences. Because the facts alleged allowed for both malicious and innocent inferences, the court determined the allegations alone did not support a strong inference of scienter.

Next, the court analyzed the allegations that Defendant instructed Rino to use an accounting technique that violated generally accepted accounting principles and Defendant failed to check the status of the customers and contracts that were used to determine Rino’s future revenue. The court found the alleged practices did not violate accounting standards, and thus the allegations did not support a strong inference of scienter.

The court determined the facts, viewed individually, were insufficient to establish a strong inference of scienter. It found, however, that holistically the first two allegations, alongside the allegations Defendant knew that Rino advanced more than $34 million to suppliers that were owned by the CEO’s relatives and Rino issued its CEO an interest-free, unsecured loan of $3.5 million to purchase a personal residence more readily supported the inference of wrongdoing. Thus, the court found Plaintiff's allegations holistically supported an inference of scienter.

Accordingly, the court denied the Defendant’s motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.


The Supreme Court and Enforcement of The Race to the Bottom: Gatz v. Auriga Capital (Part 1)

There has been a fair amount of attention given to the opinion by the Delaware Supreme Court in Gatz v. Auriga Capital, CA 4390, Del. S. Ct., Nov. 7, 2012.  The opinion contained some sharp language criticizing the use of dicta in the Chancery Court opinion.  Gordon Smith discussed the case at The Conglomerate; likewise Steve Bainbridge did so in his blog.  Steve called the Supreme Court opinion a "smackdown" and noted that it entailed the "airing of dirty laundry that doesn't make the Supreme Court look good." 

The Supreme Court took issue with the trial court's decision to use dicta to opine on legal issues not before the court.  As the Supreme Court stated:   

the court’s excursus on this issue strayed beyond the proper purview and function of a judicial opinion. “Delaware law requires that a justiciable controversy exist before a court can adjudicate properly a dispute brought before it.”  We remind Delaware judges that the obligation to write judicial opinions on the issues presented is not a license to use those opinions as a platform from which to propagate their individual world views on issues not presented. A judge’s duty is to resolve the issues that the parties present in a clear and concise manner. 

The admonition was not designed to prevent judges from speaking out about legal issues that might come before them.  Judges could do so but only if in speeches, law review articles, or other non-judicial forums.  Again, in the words of the Supreme Court: 

To the extent Delaware judges wish to stray beyond those issues and, without making any definitive pronouncements, ruminate on what the proper direction of Delaware law should be, there are appropriate platforms, such as law review articles, the classroom, continuing legal education presentations, and keynote speeches.

The odd thing about the criticism is that the practice of using dicta to speak on issues not before the court has been encouraged by the Chief Justice.  Indeed, he co-authored an article that amounted to an apology for the practice, something labeled the "Guidance Function."  As the article stated:

the Delaware judges have frequently crafted dicta to give valuable guidance to deal lawyers on unanswered questions. The Delaware courts recognize the need to wait for a live controversy to resolve an issue definitively, but fortunately they also recognize that this does not mean that they cannot, or should not, use the attention paid to a published opinion to offer guidance on uncertain but vital areas of corporate law.

The Gatz opinion even cited the article despite the criticims of the practice. 

Challenging the use of dicta while authorizing similar views in speeches and articles is not an easy distinction to make.  First, all judges occasionally use dicta.  Somehow a blanket prohibition on the practice seems impractical. 

Second, Delaware courts regularly cite articles written by their bretheren as authority.  See Keyser v. Curtis, 2012 Del. Ch. LEXIS 175 n. 129 (Del. Ch. July 31, 2012) ("A similar application of the entire fairness doctrine has been advocated by a member of this Court, although not in a judicial opinion. See Leo E. Strine, Jr., et al, Loyalty's Core Demand: The Defining Role of Good Faith in Corporation Law").  Thus, articles and dicta can have essentially the same legal effect.

The Supreme Court opinion, therefore, is far more confusing than clarifying in its instructions to lower courts. 


Padfield on The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases (Updated Draft)

I've posted an updated draft of my article, The Silent Role of Corporate Theory in the Supreme Court’s Campaign Finance Cases, 15 U. Pa. J. Const. L. __ (forthcoming), on SSRN (here).  The abstract reads as follows:

In Citizens United v. Federal Election Commission, a 5-4 majority of the Supreme Court held that corporate political speech could not be regulated on the basis of corporate status alone. In support of that conclusion, the majority characterized corporations as mere “associations of citizens.” The dissent, meanwhile, viewed corporations as state-created entities that “differ from natural persons in fundamental ways” and “have been effectively delegated responsibility for ensuring society’s economic welfare." I have argued previously that these two competing conceptions of the corporation implicate corporate theory, with the majority adopting an aggregate/contractarian view, and the dissent an artificial entity/concession view. Even if one understands Citizens United to be primarily about listeners’ rights, this stark contrast of competing theories of the corporation is difficult to ignore. At the very least, what the majority and dissent thought about corporate speakers was relevant to the question whether the campaign finance restrictions challenged in Citizens United should fall within that narrow class of speech restrictions justified on the basis of the speaker’s identity due to “an interest in allowing governmental entities to perform their functions.” Somewhat surprisingly, however, the majority was silent, and the dissent expressly disavowed, any role for corporate theory. I have previously offered some explanations for this apparent inconsistency, and concluded that an active “silent corporate theory debate” was indeed integral to the outcome of Citizens United - despite protestations to the contrary. In this project, I examine the key Supreme Court cases leading up to Citizens United to see whether a similar silent corporate theory debate is evident in those cases. I find that there is indeed such an on-going debate, and proceed to argue that in future cases involving the rights of corporations the justices should make their views regarding the proper theory of the corporation express. This will allow for a more meaningful discussion of the merits of those decisions, and impose an additional layer of intellectual accountability on the jurists.


The Election and Corporate Governance: Political Contributions and the Role of the SEC

In the aftermath of the election, attention is likely to return to the need to impose greater transparency on corporate campaign contributions.  While Citizens United ruled out most types of substantive regulation, the case specifically approved an approach  premised around greater disclosure. 

The DISCLOSURE (‘‘Disclosure of Information on Spending on Campaigns Leads to Open and Secure Elections Act of 2012’’) Act, HR 4010, seeks to do this.  The premise of the legislation is that corporations (and other organizations such as unions) must file a report with the Federal Election Commission that discloses campaign contributions. Presumably, in the aftermath of the election, this provision will again return to the forefront. 

The SEC presumably has the regulatory authority to require disclosure of this information.  Moreover, there is a strong regulatory reason for the SEC to do so.  The DISCLOSURE 2012 ACT leaves execution of these requirements to the FEC, not the SEC.  In other words, congressional intervention would largely give control over the disclosure process to another agency.  This is not an appropriate outcome and perhaps explains stories floating around that the SEC is prepared to act in this area.   


The Election and Corporate Governance: The Pressure on Dodd Frank Eased

After the election, the press noted statements by one prominent Republican that Obamacare is the law of the land.  So, in the aftermath of the election, is Dodd Frank. 

A victory for Governor Romney would likely have put pressure on Congress to repeal significant portions of Dodd Frank.  As the WSJ reports, this hope has largely evaporated.  The article noted the possibility of "small changes . . . in the next couple of years."  In other words, Dodd Frank is going nowhere and at most there may be some modest fixes, something always possible with such a long and complex piece of legislation. 

The election cycle also provided some evidence that opposition to Dodd Frank was costly at the ballot box.  One of the people defeated in this cycle was Nan Hayworth from New York.  Hayworth sponsored a number of efforts to repeal portions of Dodd Frank, including the disclosure of pay ratios.  Arguments were made that Scott Brown in Massachusetts acted to undercut provisions in Dodd Frank

With Dodd Frank no longer in doubt, certain provisions in the governance area will need to be implemented.  One is Section 952(b) and the requirement that companies disclose compensation ratios.  In addition, the Commission ought to reconsider shareholder access, the provision struck down by the DC Circuit.  With Congress having affirmed the SEC's authority to adopt a shareholder access rule, the post election cycle may be the right time to consider another effort at implementing the requirement. 


The Election and Corporate Governance: The Impact on the Courts

One place where there may be a change in the legal regime associated with corporate governance is the role played by the federal courts.  As this Blog has often discussed, the federal courts have not been particularly friendly toward corporate governance related issues. 

The Supreme Court has embarked on a deliberate policy to restrict the use of Rule 10b-5 in the context of private actions.  Janus is an example; so is Morrison.

The DC Circuit has been striking down SEC and other administrative rules while evidencing little concern with the requirement of agency deference.  Shareholder access is the obvious example.  Moreover, the trend has the potential to continue with industry challenges to the Conflict Minerals and Resource Extraction Rules.  The use of cost-benefit analysis as a basis for striking down rules such as the access rule has effectively forced agencies to direct resources away from rule writing and enforcement to economic analysis.  There is no evidence that this is the best use of agency resources and in any event it is not for a court to determine.

How important is the DC Circuit?  According to an editorial in the WSJ, the DC Circuit:

provides the only check on the burgeoning regulatory state. Congress tends increasingly to write ambiguous laws, precisely to give regulators the discretion to impose far-reaching costs on the economy without the legislators having to take responsibility for the vote.

There are currently no vacancies on the Supreme Court but some could come open in the next four years.  There are three vacancies on the DC circuit, with eight active judges.  The Obama Administration has nominated two judges to fill some of the vacancies.

Four more years of the Obama Administration means four more years of judicial appointments.  No one can predict with certainty what judges appointed for life will do.  But new appointees will change the mix of views and opinions and, in the area of corporate governance, may result in more investor friendly decisions. 


The Election and Corporate Governance: A Lesson in Demographics

If there has been a single common subject in the analysis of the 2012 presidential election, it has been the role of demographics.  Apparently something like 45% of President Obama's votes came from people of color.  He rolled up huge margins with Latinos, African Americans and, less discussed, Asians (Asians favored the President 73% to 26%). 

Then there were women, with the President chalking up a double digit lead (12%) with that group as well.  As one study noted:  "Since 1964 women have comprised a majority of the eligible electorate, but it was not until 1980 that the percentage of eligible women who actually voted surpassed the percentage of qualified men casting ballots . . . "

These demographics caused Politico to ask whether the Republican Party was Too old, too white, too male and whether this amounted to a "glaring structural weaknesses in the GOP".  See also Vote Data Show Changing Nation.

In the area of corporate governance, the exact same question can be asked about corporate boards and about the judiciary in Delaware.  Corporate boards of public companies consist of about 15% women (one study of the 1500 largest public companies put it at 12.7%) and 10% people of color.  For the most part, this means one woman and one person of color on a corporate board.

Similarly, Delaware determines the corporate law for an entire nation.  Yet, as we have noted, it is a remarkably undiverse group of judges.  There is, among the 10 jurists on the Chancery Court and the State Supreme Court, a single woman.  They often have similar backgrounds and attend similar law schools.  Moreover, as we have also noted, this lack of diversity can increasingly be contrasted with a more diverse federal judiciary. 

Corporate boards and the Delaware courts should consider whether they also have a "glaring structural weakness" that should be seriously considered.  For the Delaware courts, the lack of diversity provides another argument for preempting state statutes and transferring matters to the federal government. 

For public companies, the lack of diversity raises concerns over the quality of the board.  Companies that figure out the importance of diversity before the others may well obtain a competitive advantage in the market place.  See Essay: Neutralizing the Board of Directors and the Impact on Diversity